Types of Business Entities and How They Affect Surety Bonds

Selecting the type of entity for your company is an important decision for many reasons. Learn the basics of different company structures and how surety bond companies view them. 

 

Sole Proprietorship

 

A Sole Proprietorship is an unincorporated business with one owner that combines business and personal assets and liabilities together. A Sole Proprietorship is not considered a legal entity. A Sole Proprietorship combines income tax with the owner’s personal income taxes. 

 

Advantages of Sole Proprietorships

 

Easy to Set Up

 

A Sole Proprietorship is quick and easy to set up. Often, the owner may set up a fictitious business name, obtain licensing and that is ready to get started. 

 

Cost Effective 

 

Sole Proprietorships are cost effective. The owner saves on the cost of setting up an additional entity, preparing separate financial statements, filing separate tax returns, etc. 

 

Disadvantages of Sole Proprietorships

 

No Liability Shield

 

An owner of a sole proprietorship has no liability shield from the acts of the business. Creditors and potential claimants from the business can seek full access to the owner’s personal assets. 

 

For example, a contractor operating as a sole proprietorship strikes a gas line while digging. The gas line explodes damaging several buildings nearby. The Sole Proprietorship provides no legal protection from the owner and his or her personal assets. 

 

Surety Bond Considerations for Sole Proprietors

 

Surety Experience

 

The biggest challenge is that surety bond underwriters do not see many sole proprietorships. Therefore, they are not as comfortable supporting these businesses.

 

Most surety bond companies like to focus on the operations of the business. This can be challenging with Sole Proprietorships. Distinguishing what assets and liabilities are used in the businesses versus for personal use can be very difficult. 

 

Financial Statements

 

A third challenge for surety bond underwriters if verifying assets. Sole Proprietors often do not have their financial statements verified by a CPA. Therefore, an underwriter may have to rely on tax returns or methods of verifications such as getting bank statements, equipment appraisals and copies of loan documents. 

 

Continuity

 

Another consideration for Surety Bond Companies is that Sole Proprietorship are difficult or impossible to sell or transfer. If the owner is no longer able to run the company, there is a concern of who will be able to complete the remaining work. 

 

Indemnity

 

Because there is no separation between the business and personal assets, a bond company will expect the owner of the sole proprietorship to personally indemnify for any losses.

 

Legal Liability

 

Finally, Surety Bond Companies will be concerned about potential litigation and liability. Because Sole Proprietorships have no liability shield, a lawsuit could devastate the company and owner personally. There may be no assets left to complete bonded projects or indemnify the surety bond company. Bond underwriters will want Sole Proprietors to carry adequate insurance and limits to address potential claims. 

 

Although there are many benefits to Sole Proprietorships, they create one of the most difficult businesses for surety bond underwriters. In fact, many surety bond companies will not write bonds for Sole Proprietorships at all. 

 

Limited Liability Company (LLC)

 

A Limited Liability Company (LLC) is a legal business structure that combines the pass-through tax benefits of sole proprietorships and partnerships with the liability shield of a corporation. LLCs are organized or chartered and governed by articles of organizations. LLCs owners are typically classified as “Members” or “Organizers” and may have a Managing Member.

 

Advantages of LLCs

 

LLCs have many advantages including low costs, flexibility, ease of setting up, pass through taxation and legal protections. 

 

Low Costs

 

LLC can be set up in most states for less than a few hundred dollars. LLCs do not typically have to have annual meetings or reports and can be maintained for little capital. Most LLCs can be set up online in only a few minutes by the members.

 

Flexibility

 

LLCs have a lot of flexibility. They do not have the same rules for ownership that corporations have. An LLC can generally have an unlimited number of owners. Owners can also be foreign corporations. Additionally, LLCs have a lot of flexibility with the distribution of funds. 

 

Pass Through Taxation

 

LLC profits and losses are passed through to the members. Members receive a K-1 Form to report their position of profit, loss, distributions and deductions on a personal level. LLCs are not subject to the double taxation of Corporations. 

 

Legal Protection

 

LLCs provide legal protection from creditors and lawsuits like a corporation. Generally, the members are not personally responsible for the debts of the LLC including judgments. Members should be careful not to create a situation for “Piercing the Veil”, though which could open them up to liability. 

 

Disadvantages to LLCs

 

LLCs also have some disadvantages. These include varying state laws, and ownership transfers.

 

Surety Bond Considerations for LLCs

 

Members and Bylaws

 

Surety Bond Companies will want to look at an LLC’s bylaws. They want to know who the members are and what their roles are in the LLC. 

 

Partnerships

 

A partnership is a simple legal structure where two or more parties agree to do business together for their mutual benefit. Partnerships are typically set up in one of three ways. These include a general partnership, a limited liability partnership (LLP), and a Limited Partnership (LP).

 

General Partnership

 

A General Partnership is a legal arrangement where two or more parties share equally in the profits and liabilities of the partnership. In this arrangement all partners are legally responsible for the debts or obligations created by any other partner.

 

Limited Liability Partnership

 

A Limited Liability Partnership is a legal arrangement where two or more parties join, but the liability of each partner may be limited to their own acts. This structure is common in legal, design, and medical professions. The negligence or acts by one partner in these arrangements does not transfer to the other partners and provides a layer of protection against liability.

 

Limited Partnership

 

Limited Partnerships are a legal arrangement with at least one general partner and one or more limited partners. The general partner is responsible for the management of the business and bears full liability for the partnership. The limited partner receives a portion of the profits but their liability is limited to their investment in the partnership. 

 

Advantages of Partnerships

 

Taxes

 

Partnerships are not taxed. The partners receive a statement with their percentage of earnings and the earnings are taxed at the partners individual level.

 

Ease of Setup

 

A big advantage of partnerships is that it is the easiest way for two parties to set up a business. Partnerships can be set up very quickly and economically.

 

Resource Sharing

 

Having two or more parties means a sharing of financial resources, expertise and costs. This can be a huge advantage over a sole proprietorship.

 

Disadvantages of Partnerships

 

Legal Liability

 

Partners may not enjoy the full legal protections afforded by corporations. This can open up added liability.

 

Difficult to Transfer

 

Partnerships may be more difficult to transfer than other legal structures. 

 

Surety Bond Considerations for Partnerships

Indemnity

 

Generally a surety bond company will want the indemnity of the partnership and each partner individually. In Limited Partnerships and Limited Liability Partnerships, individuals and limited partners can be excluded from indemnity if the partnership balance sheet is strong enough to stand on its own. 

 

Insurance

 

Like Sole Proprietorships, Partnerships do not enjoy the corporate veil from legal liability. Therefore, bond underwriters will want to make sure appropriate insurance is in place to cover any potential liability and litigation so that it does not affect the partnership’s financial standing.

 

Continuity

 

Surety Bond underwriters will want to understand the partnership’s plan for continuity. It may be important to have life insurance and disability insurance on each partner. 

 

Corporation (C-Corp)

 

A Corporation is a legal structure with one or more owners created to act as a single entity. Corporations typically have Stockholders or Shareholders who are the owners of the company. These owners can collect profits through dividends and also benefit by the appreciation of the company’s value.

 

Advantages of a Corporation

 

Legal Veil

 

The biggest advantage to a corporation is that the owners are separated from the liabilities created by the company. This is one of the reasons that the largest companies in the United States are almost always Corporations.

 

Easily Transferable

 

Corporations can easily transfer ownership to an outside party, or to internal stakeholders. Because owners have stock in the corporation, their ownership value can be easier to evaluate.

 

Disadvantages of a Corporation

 

Taxation

 

Corporations pay taxes on their profits. Profits paid out to owners are dividends or distributions. The shareholder must also pay taxes on these dividends. Therefore, corporations are hit with a “double taxation” on profits. 

 

Costs

 

Corporations may also face additional legal, accounting, and regulatory costs. 

 

Surety Bond Considerations for Corporations

 

Indemnity

 

Because Corporations enjoy many protections from liability, a surety bond company will often want the individual shareholders to sign personally as well as the corporation. This varies by bond company, but the threshold is often 15% or more ownership in the company. However, many corporations have a strong balance sheet and do not need the owners to sign personally. 

 

Taxes and Distributions

 

Surety Bond underwriters will always be interested in the Corporations tax liability and planned distributions. Tax liabilities are treated as a current liability and therefore directly affect a corporation’s working capital

 

Additionally, shareholders often expect a certain level of return so distributions can negatively affect the Corporation’s balance sheet. Surety bond underwriters like Corporations to have a policy for both capital retention and distributions so that they can plan and project. This also helps avoid surprises to the bond company.

 

Management

 

Corporations may be run by individuals who are not the shareholders. Surety bond companies will want to be comfortable with the management and operations of a corporation, especially if they are not owners of the company. The bond company will also typically want a copy of the corporate resolutions and officers to know who can sign on behalf of the company.

 

Subchapter S Corporations (S-Corp)

 

Certain eligible corporations elect special status under IRS rules. These Subchapter S Corporations or S-Corps must be less than 100 employees and follow other restrictions. S-Corps enjoy pass-through taxation similar to LLCs but the legal shield of corporations.

 

Advantages of S-Corps

 

Taxes

 

S-Corp profits are passed to the company owners and taxed at the owner’s tax rate. This avoids income taxes for the corporation and double taxation. S-Corps also enjoy the ability to deduct certain items from profits to reduce the tax liability to its owners. 

 

Legal Liability

 

S-Corps provide the benefit of the corporate veil. Shareholder liability is generally limited to their investment in the company. 

 

Disadvantages of an S-Corp

 

Rules

 

S-Corps must follow several rules and are less flexible than LLCs. For example, only certain individuals, trusts, and certain corporations can own S-Corps. S-Corps must also pay owners who are employees a salary. This requires payroll tax payments that other entities do not have to pay. Finally, because a S-Corp is limited to the number of shareholders, it may limit some companies. 

 

Surety Bond Considerations for S-Corps

 

S-Corps are one of the most popular business structures in the United States. Surety Bond companies are very familiar and comfortable with S-Corps. Bond companies will want to understand the ownership structure. They will also want to understand the shareholder distributions. In certain cases, a surety bond company may ask the S-Corporation to sign a capital retention agreement. This agreement outlines that the S-Corp must keep a certain amount of capital in the company.

 

Non-Profit Organizations and 501(c)(3)

 

Non-Profit Organizations are entities established for a specific mission or purpose. Many non-profit organizations are 501(c)(3)s which are exempt from Federal Income taxes. Common examples are Religious Organizations and Charities. 

 

Bond Considerations for Non-Profits

 

What is Being Guaranteed?

 

Non-profit organizations can have a wide variety of bond needs such as Fidelity Bonds, Erisa Bonds, self-insured workers compensation bonds, and notary bonds. However, they can also have very complicated risks such as financial guarantees. Bond underwriters need to understand the obligation behind the bond being requested.

 

Restricted Assets

 

Bond companies will want to know what assets are available. Many non-profit organizations have restricted assets that may not be available to a creditor such as a surety bond company.

 

Indemnity

 

Non-profit organizations generally do not have members that can or will indemnify. Therefore, it is important for the non-profit to have the financial strength to stand on its own. 

 

Businesses should pick a setup that is good for both the long- and short-term goals of their company. Experience advisors such as attorneys, CPAs and bond brokers can help select and set up the most appropriate entity. Each type of entity can be bonded but some are more preferable than others. 

 

Vice President at Axcess Surety
Vice President of Axcess Surety. Surety Bond and financial expert dedicated to helping contractors, businesses and individuals understand and obtain surety bond credit.
Josh Carson, AFSB
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